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3 Common Methods Used To Calculate Land Value
There is a variety of methods used to calculate land value.
There are even experienced real estate investors who are able to estimate land value off the top of their head within an accuracy of 5% give or take.
And with a successful track record of investing in real estate, who are we to judge whether they are right or wrong.
However, there are 3 valuation methods most commonly used to calculate the value of a piece of land.
Before we go on to the methods, be mindful that when real estate if purchased, the purchase price consist of the price of the land and the price of the improvements (house).
This might not be listed on the sales and purchase agreement, because in practice, we only state the final closing price.
On top of that, in terms of accounting, a property is eligible for depreciation while the land is not.
With that out of the way, here are the popular land valuation methods in practice.
1) Assessed value
Who would be a better appraiser of the official value of a piece of land than the government itself?
Appraised land value is the value the authorities place on the property for the purpose of calculating property taxes.
If there’s any party you feel would not be shortchanged, it is the IRS.
While assessed value is an approximation, it should serve as a fair estimate of based on current market conditions.
Keep in mind that the county would have knowledge of zoning, master plans, macro data, etc. This makes their method of valuation based on more credible qualitative and quantitative information.
If we take for example a house you paid $200,000 for, and the assessed value is $160,000 consisting of $40,000 for land and $120,000 for the improvements (house), then it is fair to say that the value of land is 25% of the total value.
For depreciation purposes, the annual depreciation expense on improvements will be based on a $150,000 value (75% of $200,000) since land will be worth $50,000 (25%).
2) Appraised value
While a bank might make some major mistakes in it’s lifetime, they are some of the people who really mean serious business when it comes to valuing assets, especially real estate.
They make their money by lending our money or giving credit to borrowers with assets like property as collateral.
So they are professionally driven to get as specific as possible when it comes to valuations for mortgages.
This is why lenders will certainly order an appraisal conducted by a qualified appraiser, or appraise the property themselves internally.
If for example, you purchased a property for $150,000 and the bank’s appraisal comes back with $180,000 consisting of $50,000 for the land and $130,000 as replacement value of the house, then it is fair to conclude that the land value is 33.33% of the total value.
When the time of the year arrives for tabulating depreciation, the figure to work from will be based on the value of improvements of $100,000 (66.66%) as land will be worth $50,000 (33.33%).
3) Replacement value
Insurers are well known to be meticulous in financial planning.
There is almost no possible way for them to make a loss from issuing insurance policies. Otherwise every one of them would not have survived for even a decade.
Insurance for real estate is a big and booming business. There are countless types of policies that cater to landlords, investors, and homeowners.
When calculating the premium required for a policy, insurers will have to calculate the replacement cost for a house.
Otherwise there’s little point underwriting anything.
The replacement cost refers to how much it will costs to replace a house with a new one should an event happen that effectively condemns the whole house.
If you purchased a house for $250,000 and the replacement value for the house (improvements) is $175,000, this means that the land is valued at $75,000 (30%).
In any case, depreciation will be based on the improvements value of $175,000.
Do note that from the insurers’ point of view, there is no need to schedule replacement for land as it still retains it’s value if the property sitting on it is totally destroyed.
Which valuation method to use
While all 3 methods of land valuation have a different basis, how the numbers are derived can be justified in the eyes of the law.
Which one to use will then depend on your circumstances or objectives.
If you are in a situation where you can benefit by claiming as high a depreciation as legally allowed, go with one that has the lowest land value.
When in doubt, do consult a qualified tax advisor who has experience with real estate.